In Praise of Bubbles

Boom and bust cycles have always driven the US economy.

By Daniel Gross

Financial bubbles get a bum rap. People focus on the sob stories (think of the grandmothers who invested in Pets.com) and the tales of financial chicanery (think WorldCom). But bubbles - those sudden, excessive, and seemingly irrational investment stampedes - aren't all bad. Sure, they tend to follow a painful cycle of boom, bust, hand-wringing, and abject humiliation. But there's often another step at the end: innovation. Over the past 150 years, many bursting bubbles have paved the way for economic and cultural progress.

Consider the early dot-dash era. Between 1848 and 1852, the number of telegraph miles in the US jumped from 2,000 to 23,000. These efforts were largely the result of what historian Robert Luther Thompson has dubbed "methodless enthusiasm." Few entrepreneurs proved more methodless than Henry O'Rielly, who in 1845 strung a line across the sparsely populated Pennsylvania Alleghenies and dubbed it the Atlantic & Ohio Telegraph Company. Its weekly revenue in February 1846: $4.50. Then there's Cyrus Field, who was lionized when he built the first transatlantic cable in 1858 but vilified when the first line failed a few weeks after its completion - leading The Boston Courier to speculate that the whole project had been an elaborate hoax. Many of the companies that built the industry's original infrastructure had collapsed by the early 1860s.

Despite such setbacks, the telegraph became a crucial tool for American businesses. Excess capacity caused prices to plummet. As the cost of sending data dropped to a penny a word, reporters could file long stories from the Civil War battlefields, fueling the great newspaper empires of William Randolf Hearst and Joseph Pulitzer. Likewise, the spread of the ability to send cheap telegraphs spurred a national market in stocks and commodities and made it much easier to manage international business.

Next came railroads. Between 1870 and 1890, investment in the industry quadrupled and work began on four transcontinental lines. But excess capacity met cutthroat competition - and surprisingly little traffic. The Northern Pacific, capitalized at $100 million, laid just under 500 miles of track before going bankrupt in 1873. At the Erie Railroad, robber baron Jay Gould helped the company engage in Enron-esque balance sheet manipulation - and became an Enron-esque public enemy. By 1897, one-quarter of the industry was in receivership. But when the coal dust cleared, a sturdy new commercial infrastructure remained. Between 1870 and 1890, the cost of shipping a bushel of wheat from Chicago to New York fell by half. Cheap rail freight suddenly made it possible for customers to order products out of catalogs from distant retailers. Say hello to Sears, Roebuck. Soon other industries blossomed: leisure travel, restaurants relying on the transport of refrigerated food, professional sports.

During the 1990s, "methodless enthusiasm" was reborn as "irrational exuberance," and the companies that built Internet pipelines repeated the experiences of the telegraph and railroad industries. A bunch of corporate Christos aiming to wrap the globe with thin glass wires, firms like Exodus Communications and PSINet, raised and spent some $30 billion to build 90 million miles of fiber-optic cable.

Again, it was too much, too soon. In 2001, just 5 percent of the country's fiber-optic capacity was being used. Wholesale prices plummeted and high-profile executives were accused of obscene profiteering and insider dealing. Still, the nation had been wired. US schools, governments, libraries, and corporations all now enjoy fast Internet connections. Today, about 40 percent of Americans have high-speed access at home, and the price of long-haul broadband has fallen by 75 percent in the past five years.

Rampant investment also inflated the companies that used the Internet to provide new services - from Amazon.com to ZDNet - and started them on the time-honored cycle of excess capacity, price competition, scandal, death, and then innovation. Remember Enron's ill-fated deal with Blockbuster to create a video-on-demand service? An expensive trial that began in 2000 and yielded seven purchases of The Care Bears Movie. But five years later, a dozen content-over-broadband companies are thriving. By doing things like giving people cash to open online brokerage accounts (Ameritrade) and running businesses at negative margins (Webvan), the dotcoms developed the tools, processes, and habits that led to real online businesses.

The result has been a real, delayed boom. Put cheap data transmission and storage together with an exploding population of consumers willing to use the Net and you get eBay, Google, and Yahoo! Now come widespread laments that another bursting bubble is anon: real estate, genomics, China stocks, wireless Internet, you name it. Maybe so. But sometimes, a little methodless enthusiasm is precisely what an economy needs.

Daniel Gross (moneybox@slate.com) writes the Moneybox column for Slate and contributes to the Economic View column in The New York Times.